A tax cut for the middle class

China's individual income tax (IIT) reform aims to ease the tax burden for China's urban middle class. This in turn will provide a mild boost for consumption, particularly as the economy slows. However, the overall impact on income redistribution will be weak, leaving both lower- and higher-income groups relatively unaffected. In addition, higher allowances for tax exemption will also erode the broader taxpayer base.

The full revisions to China's IIT law will come into effect in January 2019, following adjustments to the minimum threshold for tax exemption, which took effect in October. The changes will be the seventh round of reforms to the IIT since it was first introduced in 1980.

Who benefits the most?

The most visible change, which came into effect in October, has been the decision to raise the monthly tax exemption allowance to Rmb5,000 (US$754), from Rmb3,500 previously. This means that a taxpayer with a gross monthly wage of Rmb10,000—roughly the average wage level in Beijing—will see her monthly tax burden (after social security payments) reduced to Rmb90, from Rmb345 previously.

In annual terms, the biggest beneficiaries will be the urban middle class. From our calculations, individuals with annual wages (after deducting social security payments) ranging from Rmb180,000 to Rmb360,000—within the threshold of our definition for China's middle class—will see the largest tax relief. In particular, the strongest benefits will be felt by people who earn a yearly wage of Rmb240,000, who will see the largest reduction in their tax (as a share of their total income).

The new tax code also adds six categories for expense deductions: housing loan interest, rent, children's education, continuing education, eldercare responsibilities and treatment for serious diseases. While these categories are applicable to most people in China, a few—such as relief geared at continuing education and on housing loan interest—seem obviously designed to cater to the middle class. For a family with one child and two grandparents living in a self-owned home, the monthly maximum deductible could reach up to Rmb4,000—or equivalent to almost 27% of income for a family earning Rmb180,000 per year.

Individual income tax deductibles

Deductible category

Monthly

Yearly

Qualifying conditions

Housing loan interest

1,000

12,000

Only applicable to loans used for first-time home purchase by either the applicant or their spouse.

Rent

800-1,200

9,600-14,400

Only applicable as long as the applicant and their spouse do not also own homes in the city in which they are working or renting a home.

Caring for the elderly

2,000

24,000

Applicable to households with elderly persons over the age of 60 years; deductibles are fixed regardless of how many elderly residents are in the household.

Treatment for serious diseases

n/a

60,000

Only applicable for expenses exceeding Rmb15,000; can only be applied once per year.

Children's education

1,000

12,000

The deductibles can be increased in line with the number of children in a single household.

Continuing education

300-400

3,600-4,800

None specified.

Note. Values are in Rmb; all items are effective from January 2019.

Sources: State Administration of Taxation; The Economist Intelligence Unit.

Not good news for all

The structure of the new law will start to levy taxes on combined incomes on an annual basis. The wage tax follows a progressive structure with seven brackets, ranging from 3% to 45%. In addition, a flat 20% rate under the IIT applies to income from dividends, remunerations, royalties and property transactions. Under the new tax code remunerations and royalties will be combined with an earner's salary under the tax brackets. The result will be a higher taxable income base for those affected.

Questions over combined income will also be particularly salient for people who derive a significant portion of their annual income from year-end bonuses. Officials have not clarified details of how the law will treat such bonuses, which have been exempted from the IIT in the past. These concerns are not insignificant: a number of industries, including finance, information technology and consulting, rely on bonuses to attract talent. Anecdotal evidence shows that year-end bonuses in these sectors can be as high as three or four times the annual wage. There is a risk that the IIT reforms could increase the tax burdens facing these companies.

Individuals with global income may also be subject to higher taxes. The law may levy taxes on the worldwide income of foreigners (including those in Hong Kong) who spend over half of each year on the Chinese mainland. This will replace the previous rule whereby expatriates are liable to pay the IIT only after being a tax resident for five years. High-income earners with foreign assets will face a similar situation. These moves are in line with China's efforts to align itself with global tax and accounting standards, particularly since the country's entry in 2017 into the Common Reporting System (CRS), an international agreement that tracks the global financial assets of residents in member countries. (Most developed countries, with the exception of the US, have signed up to this framework.) While these reforms can help tax authorities to trace assets transferred abroad, in an effort to clamp down on tax evasion, imposing taxes on global income may risk deterring higher-end overseas talent from working in China.

Shoring up government finances?

The IIT is China's third-largest source of tax revenue, after the value-added tax and corporate income tax structures. Nevertheless, contributions from the IIT to government coffers have historically been relatively modest: in 2017 IIT revenue reached Rmb1.2trn (US$177.5bn), accounting for just 8.3% of total tax revenue—far below the 24.4% average rate among OECD countries.

One big constraint has been the narrow base of the IIT, which only applies to a fraction of urban workers. This situation is unlikely to change. Although official data are largely unavailable, a media interview with the Ministry of Finance in August 2018 suggested that the IIT reform will reduce the number of income tax payers from 187m previously to 64m, meaning that the tax base will comprise less than 5% of China's population, in sharp contrast to 43% in the US and 33% in South Korea.

The tax burden is also unevenly applied across sectors and regions. Tax revenue from financial services, manufacturing, leasing, retail and property contributed around 60% of the national IIT in 2017. Employees in the financial services sector contributed around 19.1% of IIT revenue that year, exceeding that industry's share of China's GDP (at 7.9% in 2017). By contrast, employees in the manufacturing sector contributed around 14.8% of IIT revenue in 2017, even as that industry accounted for 29.3% of GDP in the same year.

Developed areas with a stronger concentration of higher-paying industries thus bear a heavier IIT burden; in 2017 Beijing, Shanghai, Guangdong and Jiangsu contributed more than half of national IIT. There is also divergence between public and private enterprises; payments from employees of state-owned enterprises comprised only 6% of IIT revenue in 2017, with the remaining 94% coming from employees in the private sector.

Tax evasion remains prevalent, even as authorities have geared up enforcement efforts in 2018. These moves started with a few high-profile cases in the entertainment industry; China's highest-paid actress, Fan Bingbing, was ordered to pay Rmb884m (US$133.3m) in overdue taxes and fines in October 2018, after a period of detention by state authorities. Despite these high-profile moves, the majority of tax evasion still occurs off-radar, particularly in smaller cities where enforcement supervision is not as robust.

While the introduction of deductibles represents a major change to the tax structure, it also complicates the system significantly and increases the risks of tax evasion, despite the surface veneer of appearing more "fair". Deductibles for the treatment of serious diseases are only applicable once a year, even if treatment is required several times over that period or for several years. Deductibles for eldercare are applied at a set uniform rate across all families, even if some households have more elderly residents than others. There is also a lack of regional variation to reflect differences in living costs across China.

The move to reduce the tax burden came as China faces increasing economic headwinds, as well as escalating trade tensions with the US and a plunging stockmarket. Any boost to consumption will probably only be mild, given the small taxpayer base, while other issues are looming on the horizon; household debt has been increasing rapidly, mostly in home mortgages. If the current situation continues, debt growth will easily wipe out any economic gains derived from the tax cut.